Splits, Reverse Splits, and Why Apple and Google Are Not on the Dow

Splits have fallen so out of favor that Coca-Cola will be the first blue-chip to split since 2005. What are they and why should investors care?

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MINYANVILLE ORIGINAL

It's stupid. If you own 10 shares at $40, or one share at $400, it's the same thing! You just need to know how to divide.
--Larry Page

In light of his oft-cited quotation above, it was more than a little ironic to see Google's (GOOG) co-founder recently reverse himself and back the search giant's first stock split since going public eight years ago. Page had nothing to say regarding his about-face, having conveniently lost his voice for the occasion, but the de facto 2-for-1 split was especially contentious as it effectively consolidated his power, involving as it did the creation of a Class C stock that is devoid of voting rights.

Page is not the only high profile investor to speak out on stock splits. None other than Warren Buffett rhetorically asked shareholders in a 1983 letter: "Could we really improve our…group by trading some of present clear-thinking members for impressionable new ones who, preferring paper to value, feel wealthier with nine $10 bills than with one $100 bill?"

Omaha's oracle long viewed stock splits with disdain due to their tendency to foster the mindset of a mere trader, as opposed to a farsighted owner. Yet in 2010 he approved a 50-for-1 split of 'baby' Berkshire Hathaway (BRK-B) stock to finance the company's $26 billion acquisition of Burlington Northern Santa Fe railroad. (Berkshire's (BRK-A) class 'A' stock, currently trading at about $125,000, hasn't split since Buffett assumed control in 1965.)

Let us look then at stock splits, a deceptively straightforward corporate action that has caused some of America's most successful businesspeople to flip-flop so spectacularly.

Basics

A stock split is simply a device that increases the number of a company's shares outstanding by dividing each one by a set amount, which in turn diminishes its price. The market capitalization therefore remains the same. Common split ratios are 2 for 1, 3 for 2, and 3 for 1.

For example, an owner of 100 shares of company XYZ trading at $50 per share will, once a 2-for-1 split takes effect, now have 200 shares worth $25 each. A slice of pizza has essentially been split in two but the overall amount of pie is intact.

On rarer occasions, as in the instance of Marriott (MAR) in 2009, a stock dividend will be made in lieu of a split. Recent examples of splits include Dollar Tree (DLTR), whose 2-for-1 occurred on June 26, and Brown Forman (BF-B), which will split 3-for-2 on August 10. Both issues have been trading at all-time highs of late, which is indicative of a common theme of stock splits. They are invariably seen as psychologically positive, a sort of confidence vote by company management.

Splits are closely associated with booming markets, and tend to dry up when times get tough. Indeed they reached a record of 23% of all US firms in 1982, at the beginning of Wall Street's biggest-ever bull run, and enjoyed a renaissance in the Internet bubble of 1999. During these heady times tech companies in particular split at dizzying speeds and websites would even spring up to try and predict when the next one would occur.

Impact

In their heyday, splits were seen as a win-win proposition for both brokers, who typically generated fatter fees on transactions involving lower-priced stock, and individual investors, who wanted to avoid the penalty that resulted from "odd lot" purchases involving fewer than 100 shares.

Although splitting stock has no effect on underlying value, the perception of greater 'affordability' and liquidity that result can become self-fulfilling, attracting even greater interest.

More often than not, the day of the split sees a spike in volume relative to other NYSE (^NYA) issues, and price gains often occur in the immediate aftermath. In the case of Berkshire for instance, the mere announcement of a split was enough to send it up 1.8% on the session. Yet prices tend to revert to the mean after only a few days, and a 1985 analysis showed that underlying volatility surges by 30% over the subsequent 12 months.

Famed University of Chicago economist Eugene Fama was the first to study stock splits in detail 40 years ago. His analysis showed that splits ultimately had no long-term effect on share price performance. More recently, in 2004 researchers at the Yale School of Management discovered that institutional investors are more likely to sell, and retail investors more inclined to purchase, shares that have recently split.

Ah, the immortal words of William Shatner, back when he commanded the Starship Enterprise. At the risk of offending rekkies, English teachers the world over would say Captain Kirk's use of such a split (so to speak) infinitive is awful English. As, indeed, is the double negative long employed by Sara Lee, namely that "nobody doesn't like" it. Yet in 2003 Priceline.com (PCLN) conducted a 1-for-6 reverse stock split while Mr. Shatner was its spokesman, while Sara Lee, now known as Hillshire Brands (HSH), just split on a 1-for-5 basis.

It is almost impossible to recall now, with Priceline shares trading at over $670 to boast the single highest stock price in the entire S&P 500 Index (^GSPC), but the online travel outfit could be bought for barely $2 nine years ago. Accordingly, it embarked on a reverse split amid real concerns a delisting was inevitable. More recently, Duke Energy (DKE) underwent a 1-for-3 reverse just this month.

Such actions are invariably undertaken as a way of reducing the number of total shares outstanding while enabling the issuer to continue meeting stock index listing requirements pertaining to minimum prices. The Nasdaq (^IXIC) for instance sets its lowest threshold at $1.00 per share. However, absent simultaneous underlying structural change at the company, these measures are often seen as mere marks of desperation akin to shuffling deck chairs on the Titanic. Management may be looking for a short-term credibility boost, but investors often question why the stock price had sunk so low in the first instance.

Indeed, a study conducted by both NYU's Stern School of Business and Emory University examined over 1,600 reverse splits done from 1962 through 2001. The findings revealed that, three years after a reverse split, the equity in question had underperformed its unsplit peers by a 54%, a negative divergence which became even more pronounced when the issue traded at under $5 at the time of the action. (Many mutual funds are prevented from purchasing a stock that falls below this threshold.)

Examples of high-profile companies that have engaged in reverse splits when they had no other answer to troubled times include American International Group (AIG), the insurer doing a 1-for-20 in July of 2009 after essentially going belly up in the 2008 financial crisis. And Citigroup's (C) 1-for-10 in May of 2011 was powerless to prevent its stock sinking 24.28% in the subsequent three months amid accusations it was taking investors for fools with what was seen as simply a corporate slight of hand.

It should be noted that sometimes reverse splits have more innocent explanations. Examples from recent years include Time Warner (TWC) and Tyco International (TYC), each of which embarked on one as a way to cleanly siphon off specific units to investors.

Why Splits Are Outta Here

Stock splits have become something of an endangered species in recent times, with a mere dozen taking place in 2011 compared with as many as 100 some 15 years ago when the late 1990s boom began in earnest.

There are several reasons for splits falling from favor. These include firms trying to avoid the higher expenses and increased fees that result from having ever more outstanding shares. Broker commissions have also evolved, with less emphasis now placed on pedaling droves of lower-cost issues.

Of arguably greater importance, high prices no longer seem to scare off investors – certainly not when the market is increasingly dominated by institutions and price-agnostic exchange traded vehicles as opposed to individuals. Indeed many CEOs now view a triple-digit share price as a veritable badge of honor.

As a result, what was once rare has become almost dime-a-dozen. A record 47 stocks presently trade at over $100 per share and some, such as Mastercard (MA), command in excess of $400. Fast-food firm Chipotle Mexican Grill (CMG), a single share of which will set you back approximately $380, is similarly slow to warm to stock splits, having never announced one in its six years as a public company.

Considering that splits are seen as little more than superficial gestures, their demise has had some surprisingly profound consequences. The much-discussed evaporation of trading volume on Wall Street of late can be at least partially ascribed to the occurrence of far fewer splits. This situation is exacerbated by the mopping up of excess equity created by reverse splits. In fact Rosenblatt Securities Inc estimated that Citigroup's reversal alone accounted for roughly 6.1% of lost volume in the final eight months last year.

The reduction in stock splits is even exerting a major impact on the makeup of world's most prestigious equity index. As currently constituted the Dow Jones Industrial Average (^DJI), being price-weighted, effectively excludes some of the most influential companies on Earth from joining due to their lofty levels. Chief among these are of course Apple Inc. (AAPL) and Google (GOOG), which many market mavens suggest should really be shoo-ins for membership.

Looking Ahead

Interestingly, in April Dow member Coca-Cola (KO), which reached a fresh 52-week peak at the start of this month, announced its first stock split in some 16 years. The proposed 2-for-1 distribution, subject to shareholder approval this week, already counts one prominent investor among those voting 'yes.' That would be none other than Howard Buffett, whose pop Warren owns 200 million shares of the Atlanta soft drink giant. The split, Coke's 11th in its history, is set to be the first by a blue chip since Caterpillar (CAT) in 2005.

All of which brings the subject back to Apple, which similarly split for the last -- or should that be latest? -- time seven years ago. Back then its third split, a 2-for-1, occurred at about $80.

At this year's annual shareholder meeting in February, CEO Tim Cook appeared to pooh-pooh the idea of another, saying they "do nothing" for shareholders. Yet with Apple now back above $600 and trading at its highest price in three months, splitting may not be so bananas. Especially when the Cupertino company could probably guarantee its admittance into the prestigious Dow Index in an instant by adopting such a measure.

Will Cook become but the latest executive to end up with egg on his face in dismissing stock splits? Watch this space.

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